Mac storage basics · Time Machine basics
Does Time Machine back up files in iCloud Drive?
Short answer: Only files actually stored on the Mac. Online-only iCloud files aren't downloaded for backup, and syncing isn't a backup, so keep an independent copy if you need one.
Time Machine backs up what is actually stored on your Mac. Files kept only in the cloud (online-only, as with Optimise Mac Storage) aren't downloaded just to be backed up, so they aren't in your Time Machine backup.
iCloud keeps its own copy, but syncing isn't a backup: a deletion syncs everywhere. If you need an independent copy of everything, download it and back it up, or use a backup tool that copies from the cloud. See backups.